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International Currencies Past, Present and Future: Two Views from Economic History Barry Eichengreen November

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The history of the international economy is often told in terms of the rise and fall of leading powers. – Angus Maddison told it in terms of leaders and followers and the moving technological frontier. – Charles Kindleberger told it in terms of the changing identity and but unchanging importance of the lead economy. This story is typically told in terms of British hegemony in the 19 th century (the imperialism of free trade, the availability of cheap cotton, with Britain still the leading trading and exporting nation as late as 1913) and U.S. hegemony in the 20 th – followed by Chinese hegemony in the 21 st ? 2

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The same story is often told through the lens of currencies The 19 th century international economy (first age of globalization, era of the gold standard) was organized around and dominated by sterling. – As in Marcello de Cecco’s work on the gold standard. – As in Keynes’s Treatise, where the Bank of England was “conductor of the international orchestra.” The 20 th century international economy (or at least the international economy of the second half of the 20 th century, sterling remaining dominant as late as WWII) was organized around and dominated by the dollar. – As in Ronald McKinnon’s writings on the “gold-dollar system” and “global dollar standard.” Suggesting that the 21 st century international economy will be organized around and dominated by the Chinese RMB. – As suggested in Arvind Panagariya’s recent writings. 3

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This view is supported by theory Network externalities are powerful. – It pays to use the same currency that others also use. It follows that international currency status is a natural monopoly. – There is room in the global economy for only one consequential global currency (first it was sterling, now it is the dollar, in the future it will be the RMB). First mover advantage is strong. – Advantages of incumbency flow from network increasing returns. It follows that persistence is strong. – Thus, an international currency can retain its dominance long after the issuer has since lost its economic, fiscal and political capacity to provide international currency services on the scale required by an expanding global economy, reflecting the hold of network effects. Resulting in liquidity shortages in the 1920s and 1930s? Resulting in global imbalances and doubts about the dollar after the turn of the century? This perhaps helps us understand the chronic fragility of the international monetary system, something that has long intrigued economic historians (and troubled policy makers). 4

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This view is supported by a considerable body of theoretical literature Krugman, Paul (1980), “Vehicle Currencies and the Structure of International Exchange,” Journal of Money, Credit and Banking 12, pp Krugman, Paul (1984), “The International Role of the Dollar: Theory and Prospect,” in John Bilson and Richard Marston (eds), Exchange Rate Theory and Practice, Chicago: University of Chicago Press, pp Matsuyama, Kiminori, Nobuhiro Kiyotaki and Akihiko Matsui (1993), “Toward a Theory of International Currency,” Review of Economic Studies 60, pp Rey, Hélène (2001), “International Trade and Currency Exchange,” Review of Economic Studies 68, pp – These theoretical contributions influence, for better or worse (and I will suggest, not entirely better) what economic historians write. 5

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But that work is based on a limited empirical foundation We know something about the currency composition of foreign exchange reserves in the decade leading up to WWI, courtesy of Peter Lindert. – “Key Currencies and Gold, ,” Princeton Studies in International Finance (1969). We know something about this since 1973 courtesy of the IMF’s COFER data base. – But we know little if anything of a systematic nature in between. 6

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In this lecture… …I will report on a research project in which I have been engaged for some years (with collaborators like Marc Flandreau, Arnaud Mehl and Livia Chitu) that seeks to fill in the gaps. The results challenge the conventional wisdom as I describe it above. They suggests replacing the traditional (or “old”) view of international currencies with a new view. – You can see from this terminology which view I favor. 7

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Two views from economic theory Old view: network effects – It pays to do what everyone else is doing. – Once a standard is widely adopted, it becomes locked in. – First-mover advantage is strong. – Because of increasing returns, only one global currency can exist at a point in time. – The dollar’s dominance for the last 50 years is evidence of this. – The old view suggests that dollar dominance will continue. New view: open systems – Interchangeability costs are not that high. – Hence increasing returns are not that strong. – First-mover advantage can be overcome relatively quickly. – Multiple international currencies can coexist. – The new view suggests that the dollar will have rivals sooner rather than later. 8

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There is theoretical support also for this new view, but a different kind Joe Farrell and Paul Klemperer, “Coordination and Lock-In: Competition with Switching Costs and Network Effects,” Handbook of Industrial Organization (2007). Paul David and Julie Bunn, “The Economics of Gateway Technologies and Network Evolution: Lessons from Electricity Supply History,” Information Economics and Policy (1988). David Clark, “The Design of Open Systems” (2003). – Though not much application previously to international monetary relations. 9

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More importantly to us, there is historical support Practice of holding foreign exchange reserves was largely ad hoc before Nonetheless, courtesy of Peter Lindert we know something about their composition. Lindert had to make a number of heroic assumptions, admittedly, when constructing these estimates. But the result, for what it is worth, is not obviously consistent with the “old” or “natural monopoly” view. 10

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More important, there is historical support Practice of holding foreign exchange reserves was largely ad hoc before Nonetheless, courtesy of Peter Lindert we know something about their composition. Lindert had to make a number of heroic assumptions, admittedly, when constructing these estimates. But the result, for what it is worth, is not obviously consistent with the “old” or “natural monopoly” view. 11

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We also have detailed case studies Courtesy of Stefano Ugolini (European Review of Economic History, 2012), we know something about the foreign exchange portfolio of the National Bank of Belgium at mid-19 th century, for example. NBB was one of the first central banks to accumulate a substantial foreign exchange reserve portfolio. The composition is not obviously consistent with the natural monopoly view. 12

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Then the 1920s Some might dismiss the preceding evidence on the grounds that forex reserves played a relatively limited role before But this was no longer true in the 1920s. Formalization of previous ad hoc practice of supplementing gold with forex reserves. Response to perception of global gold shortage. This indeed facilitated some increase in the share of forex in total reserves relative to the prewar period. – To some 30% of total central bank reserves on the eve of the Great Depression. 13

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What do we know about the composition of forex reserves in this period? The answer is: remarkably little. We have assertions by Robert Triffin that sterling continued to dominate as late as 1938 and, indeed, during World War II. – Robert Triffin, Gold and the Dollar Crisis (Yale 1960). But these are assertions, not historically documented facts. – Motivating the Eichengreen- Flandreau –Mehl-Chitu research project. 14

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What we find is inconsistent with the old or natural monopoly view Here is our reconstruction of the global picture circa – Notice very similar shares of dollars and sterling. – Note also how the franc and the mark essentially disappear from the picture. Entry still is not free. Global forex reserves,

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We can buttress this view by considering also the other roles of an international currency (in addition to its role as a form of international reserves also as an international unit of account, means of payment, private store of value). – Unit of account, means of payment and store of value being the three core functions of “money.” 16

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Evidence on currency denomination of trade credit 17

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Evidence on currency denomination of international bonds 18

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Currency denomination of international oil market transactions 19

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So why wasn’t this appreciated previously? Thank you Spain! This picture provides a sense of how quickly the dollar rose to prominence (from a standing start). – Appears to overtake sterling by the mid-1920s. Why wasn’t this appreciated? – Perhaps because much of the ground it gained in the 1920s was then lost in the unstable 1930s, as central banks liquidated their forex reserves. For Norway, Italy, Spain and Switzerland we have a continuous run 20

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Data for a larger group of countries shows same thing Again we see the dollar’s overtaking sterling by 1925, the maintenance of diversified central bank forex reserve portfolios in the second half of the 1920s, and liquidation in the 1930s. We see also how subsidiary currencies were not very popular (though the French franc gains some ground in the 1930s). Speaks to the question of whether they might be popular now (or whether scale, network effects, and liquidity favor large- country providers). Ten major reserve holders 21

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The Leverage Cycle Also illustrates the procyclical nature of this kind of monetary system. When confidence is rising, central bank reserves are being augmented, enabling to expand credit. When confidence is shocked, the reserve liquidation that follows leads to an endogenous contraction of credit, further undermining confidence. Again we see why there was and is dissatisfaction with this system. – See Ben S. Bernanke, “The Macroeconomics of the Great Depression,” Journal of Money, Credit and Banking (1995). Ten major reserve holders 22

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The Bank of France of course being a big player in the accumulation of forex reserves starting in 1926 and a big player in the liquidation first of sterling and then of dollars. France is indicative of the forex liquidation that followed 23

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This period also sees some regionalization of forex holdings Sterling remaining more popular in the Sterling Area, the dollar in much of Latin America. Relates to the question of whether we should see the emergence of the RMB as a reserve currency as mainly a regional phenomenon affecting Asia or a global phenomenon. 4 Scandinavian countries here 24

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What then happened after WII? Again, the picture is a bit opaque. Typically, analyses start in the 1970s, when the IMF’s COFER data become available. – For example Jeffrey Frankel and Menzie Chinn, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” NBER Working Paper no (2005). But, using archives, it is possible to do better. 25

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This may be the first continuous series on reserves since 1945 Note sterling’s immediate postwar dominance but also subsequent decline. Dollar’s rapid rise through mid-1960s but then leveling off. 26

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This makes it look like there was a change in reserve management in mid-to-late 1960s Dollar share stabilizes and shows some signs of decline. One sees the appearance of the deutschmark, the French franc and eventually other rivals to the dollar and sterling saw the collapse of the gold pool, agreement on the SDR then saw the final collapse of the Bretton Woods System, which contemporaries anticipated as heralding a shift away from dollar pegs and dollar reserves. Now at constant exchange rates 27

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This makes it look like there was a change in reserve management in mid-to-late 1960s If we estimate conventional models relating reserve shares to: – Issuing country size as a measure of network effects – Lagged shares as a measure of inertia – Inflation and depreciation as measures of policy credibility The Chow Test statistic reaches a peak in – Before the breakdown of BW, although not before the breakdown of BW was foreseen. Now at constant exchange rates 28

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The dominant impression is one of stability, though there are small changes Network effects grow weaker. – Consistent with the “new view” of reserve currency competition. Inertia grows stronger – Habit formation? With sterling’s decline, absence of alternatives? Policy credibility becomes more important. – Though change from pre- to post-1973 period is insignificant. 29

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The other point evident from the figure is how the absence of alternatives continues to support the dollar. One can also see why the euro was seen as a potential challenger to this hegemony. And also how the euro crisis has represented a setback. The other thing that comes through is the very limited role played by other, subsidiary currencies. First continuous series… 30

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A point that is perhaps more clearly evident here… 31

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So what does this history imply for the future? Strong persistence (habit formation) means a continuing role for the dollar (absent steps that undermine U.S. policy credibility). But that network effects are not everything suggests that there can be supplementary sources of international liquidity, like the RMB. That’s good, given the inability of the U.S. to continue to be the sole supplier of international liquidity to a global economy that is expanding more rapidly than the U.S. And 1920s history suggests that such supplementary sources of liquidity can acquire a role quite rapidly (contrary to the “old view”). 32

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But what alternative sources? 33

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This one? 34

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And this one? 35

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In its latest annual report, the ECB reported that the euro’s reserve-currency role was eroding The euro’s share in world currency reserves declined has declined from 28% at its peak in 2009 to 24% in the most recent quarter. It accounts for 25% of international debt securities, again down slightly from prior years. 36

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For this to change, Europe will have to draw a line under its crisis Will it? I have my doubts. We may want to pursue this in the Q&A. 37

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China, too, faces challenges An attractive international currency has three essential attributes: size, stability and liquidity. The dollar could rise quickly in the 1920s because the U.S. had: – Size (U.S. financial markets being larger than British financial markets – see Rousseau & Sylla). – Stability (no financial crises between 1915 and 1929 – though what came after was proof by counterexample). – Liquidity (establishing a central bank to backstop domestic financial markets and provide liquidity to the market in dollar- denominated trade credits in 1914). Chinese financial markets currently lack the requisite size, stability and liquidity – the country will have to work hard to attain them. 38

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Finally, one can ask whether China’s politics are compatible with its monetary ambitions All reserve currencies in history have been the currencies of republics or democracies. Both Britain and the U.S. had contested elections and political systems that limited arbitrary action by the executive. That was important for fostering investor confidence (on the part of both domestic and foreign investors). Freely contested elections and limits on the prerogatives of the executive are not exactly characteristics of China’s political system. 39

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Might China be able to establish limits on arbitrary executive action? The general secretary of the Communist Party is increasingly constrained by the National People’s Congress and its diverse interests. Other bureaucratic decision makers are increasingly constrained by requirements of transparency and disclosure. Internet-based movements are forcing Chinese policy makers to strengthen labor and environmental standards. Why not creditor rights? Key policy makers (the PBOC) could be given independence from politics. – Will this be enough? Only time will tell. 40